Competition for Lessees Drives Concern Over Capital Improvements Among REITs, According to BDO Study

Chicago – Despite recent surges, equity markets have remained largely unimpressive in 2014. However, REITs were still identified as a strong investment at the beginning of 2014, despite ongoing interest rate uncertainty. In an attractive REIT market, investors and real estate professionals would be prudent to stay abreast of the top risk concerns facing the sector. According to a report issued by BDO USA, LLP, a leading accounting and consulting organization, 82 percent of REITs cite risks relating to operating expenses and costs of capital improvements, up from 77 percent last year. Additionally, the financial condition of tenants continues to remain a concern, with 79 percent citing it as a risk (up from 75 percent last year).

The 2014 BDO RiskFactor Report for REITs, which analyzes the most recent SEC 10-K filings for the 100 largest publicly traded REITs in the U.S., finds that risks related to competition for lessees and prime real estate continues to rank third for a second consecutive year, cited by 94 percent of REITs. Competition to attract strong lessees across a number of real estate sectors, including commercial, retail and multi-family, could be resulting in property managers and/or owners having to renovate and make capital improvements based on tenant demand.

"Successful real estate properties are often dependent on two factors: the ability to secure strong lessees and the ability to secure adequate financing," Stuart Eisenberg, partner and Real Estate practice leader at BDO USA, LLP. "In the recent past, high unemployment numbers, low spending, limited capital and generally poor economic conditions exacerbated these risks across the entire industry. In this emergence period, we are seeing strong competition among real estate segments like high-end retail."

The following chart highlights the top 25 risk factors cited by the 100 largest U.S. REITs:

2014 Rank

Risk Factor Cited in 10-K Filing

2014

2013

2012

1.

General economic conditions

100%

100%

100%

1t.

Failure to qualify as REIT; Ability to make distributions

100%

100%

100%

3.

Strong competition for lessees and prime real estate

94%

96%

93%

4.

Inability to acquire capital or financing

93%

94%

97%

5.

Increases in interest rates; Hedging risks

90%

88%

92%

6.

Environmental liability

89%

90%

91%

6t.

Inability to sell properties quickly

89%

82%

89%

8.

Inadequate insurance and potential losses due to uninsured liabilities

87%

87%

86%

9.

Federal, state or local regulations

86%

85%

94%

9t.

Anti-takeover and change of control provisions

86%

80%

84%

11.

Tax laws and potential rates increases

85%

83%

79%

11t.

Mergers and acquisitions, joint ventures and partnerships

85%

82%

90%

11t.

Natural disasters, war, conflicts and terrorist attacks

85%

90%

83%

11t.

Payments of common and preferred stock

85%

68%

68%

15.

Debt or financial covenant restrictions

83%

76%

79%

16.

Operating expenses and costs of capital improvements

82%

77%

80%

17.

Financial condition of tenants

79%

75%

71%

18.

Ability to attract and retain key personnel

76%

67%

68%

19.

Indebtedness

75%

85%

90%

20.

Declines or stagnation in business and real estate values; Asset impairment

Gradually Rising Interest Rates Likely Manageable. Similarly to previous years, interest rates continue to be a top risk identified by REITs, with 90 percent citing it as a risk, up from 88 percent last year. There are several concerns around the impact of rising interest rates as a result of the Federal Reserve's tapering of quantitative easing practices. Notably, the potential negative impact on REIT returns, which could make other investments like bonds more attractive, especially if there is a sharp spike in interest rates and cap rates. However, a gradual move in interest rates is expected to allow time for upward adjustments in rent and net operating income (NOI), thus mitigating the impact of higher interest and capitalization rates down the road.

Pricing Drives Illiquidity Concern. REITs' concern over illiquidity and an ability to sell properties quickly rose to 89 percent from 82 percent last year. Intensifying this risk is the increase in pricing rates. Properties are likely being priced to hedge against unfavorable cap rate adjustments, and appetites on the buy side may be lacking or unwilling to accept the pricing increase. Prime A real estate markets and secondary and tertiary markets face dichotomous illiquidity issues. In recent years, prime A markets, like New York and Chicago, offered attractive pricing on properties that were also likely able to continue to perform in a troubled economy. Post recession, stability can be found in these markets but pricing may be inflated for current demand. Secondary and tertiary markets continue to face illiquidity challenges of an entirely different ilk--one in which debt financing remains scarce, even to acquire desirable assets.

Insurance Risk Raises Underwriting Issues. In previous years, natural disaster threats (90 percent in 2013) drove REIT concern over insurance premiums as well as the risk of being uninsured for liabilities. While from a business interruption and property damage perspective natural disasters and insurance risks remain a top concern (cited by 85 percent and 87 percent of REITs respectively), the expiration of the Terrorism Risk Insurance Act (TRIA) is creating new insurance-related challenges. TRIA is an act passed in 2002 that provides a federal backstop for terrorism losses and requires commercial insurers to offer affordable terrorism insurance. This regulatory change could have a strong impact on debt financing deals when lenders require such insurance to be in place. A recent survey by the Mortgage Bankers Association suggests the impact could be huge: "of $1.5 trillion in outstanding commercial and multifamily mortgages, $1.1 trillion (70 percent) of mortgages required terrorism insurance.

Concern over Cyber Security Spikes. As businesses at large face an increased risk in cyber threats, from malware, to calculated, organized cyber crimes, the number of REITs that cite security breaches as a concern jumped to 63 percent from 39 percent in 2013. However, similarly to last year, cyber security may be a larger issue in other industries--e.g., retail, where consumer data is abundant, or technology, where sensitive information is targeted.

The 2014 BDO RiskFactor Report for REITs examines the risk factors in the most recent 10-K filings of the largest 100 publicly traded U.S. REITs; the factors were analyzed and ranked by order of frequency cited.

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